Knowledge that Transforms

In this paper we examine whether regulation can be used to substitute for internal monitoring mechanisms (percentage of outside directors, officer and director common stock ownership, and CEO/Chair duality) to control for agency conflicts in a firm. We find that, in general, the percentage of outside directors is negatively related to insider stock ownership, but is not affected by CEO/Chair duality. CEO/Chair duality is, however, less likely when insider stock ownership increases. We find these internal monitoring mechanisms to be significantly less related with regulated firms (banks and utilities). We conclude that to the extent that regulations reduce the impact of managerial decisions on shareholder wealth, effective internal monitoring of managers becomes less important in controlling agency conflicts.

The paper investigates, from the welfare and growth point of view, the determination of the optimal capacity of the banking system. For that purpose, we consider an overlapping generation model with endogenous growth. There is horizontal differentiation and imperfect competition in the banking sector. Macro-economic shocks affect the return on capital and, together with the expectations of depositors, condition the stability of the banking sector. We specify to what extent deposit insurance may reduce instability and increase the number of deposits, welfare and growth. We also characterise the conditions under which excess banking capacities may appear and how their reduction may improve welfare.

We explore for individual banks, active in the East Asian countries during the years 1996–1998, the performance of three sets of indicators of bank fragility that can be computed from publicly available information: accounting data, stock market prices, and credit ratings. We find significantly different patterns among the three groups of indicators in their ability of forecasting financial distress at a specific point in time and over time. More specifically, in the East Asia crisis episode the information based on stock prices or on judgmental assessments of credit rating agencies did not outpace backward looking information contained in balance sheet data. Stock market based information, though, has responded more quickly to changing financial conditions than ratings of credit risk agencies. Overall, the evidence supports the policy conclusion that, where the information processing is quite costly, as in most developing countries, it is important to use simultaneously a plurality of indicators to assess bank fragility.

We examine the interplay of markets, ethics and law, and rising demand for ethical behavior in a market driven society coping with the promise and peril of rapid technological innovation. We analyze the market affecting role of our Common Law/Rule of Law System, its adaptability to social need, and resultant legal and regulatory action promoting adherence to the spirit as well as the letter of the law. We provide examples of manager and firm harm from sanctions imposed despite adherence to “the rules.” Finally, we discuss competitive market-common law interplay in the coming era of the genome.

Expected shortfall (ES) in several variants has been proposed as remedy for the deficiencies of value-at-risk (VaR) which in general is not a coherent risk measure. In fact, most definitions of ES lead to the same results when applied to continuous loss distributions. Differences may appear when the underlying loss distributions have discontinuities. In this case even the coherence property of ES can get lost unless one took care of the details in its definition. We compare some of the definitions of ES, pointing out that there is one which is robust in the sense of yielding a coherent risk measure regardless of the underlying distributions. Moreover, this ES can be estimated effectively even in cases where the usual estimators for VaR fail.

In the first part of this paper we address the non-coherence of value-at-risk (VaR) as a risk measure in the context of portfolio credit risk, and highlight some problems which follow from this theoretical deficiency. In particular, a realistic demonstration of the non-subadditivity of VaR is given and the possibly nonsensical consequences of VaR-based portfolio optimisation are shown. The second part of the paper discusses VaR and expected shortfall estimation for large balanced credit portfolios. All standard industry models (Creditmetrics, KMV, CreditRisk+) are presented as Bernoulli mixture models to facilitate their direct comparison. For homogeneous groups it is shown that measures of tail risk for the loss distribution may be approximated in large portfolios by analysing the tail of the mixture distribution in the Bernoulli representation. An example is given showing that, for portfolios of lower quality, choice of model has some impact on measures of extreme risk.

Rational expectations must not be expected to change. Hence, a rational expectation about a future random quantity follows a pure martingale until the uncertainty is resolved. This implies that the expectation itself could be non-stationary and, in fact, is non-stationary if the increments are iid. Most asset prices are functions of expectations about future quantities, so asset prices also could be non-stationary. This has consequences for tests based on prices rather than on returns.

We use a sample of failed thrift auctions to examine if regulators learn from early transactions and improve their performance in later transactions. Our findings suggest that experience at failure resolution does not by itself lead to improved regulatory performance. Evidence of regulatory learning is restricted to dealings with repeat acquirers; in cases where an acquiring firm makes abnormal gains, regulators are able to restructure the auction process and eliminate such gains in subsequent acquisitions made by the same acquirers.